Are Adjustable Rate Mortgages Standardized?
February 7, 2000
"After reading a column of yours about all the things a borrower needs to know about adjustable rate mortgages (ARMs), I'm wondering how I juggle all these things when I shop for an ARM? Is there any standardization of features in this market that would allow me to focus my shopping on, say, just the rate and points, as I would if I were shopping for a fixed-rate mortgage (FRM)?"
To answer this question, I recently examined the ARMs offered by 16 major lenders. I found that most of the ARMs fell into two groups, one of which has tremendous diversity while the other has become fairly well (although not completely) standardized.
The first group of ARMs is designed mainly for borrowers who have difficulty in qualifying without a low initial interest rate. These ARMs adjust the rate frequently -- every month, every 3 months or every 6 months -- and many allow negative amortization and rising payments in the future.
You can read about one popular ARM of this type in Is a 3.95% ARM a Good Deal?
The focus of this column is the second group of ARMs, which is much easier to shop because of extensive, although not complete, standardization.
The major departure from standardization within this group applies to 5-year ARMs, which are now second only to one-year ARMs in popularity. Many borrowers taking 5-year ARMs are needlessly exposing themselves to a risk that can be avoided by more careful attention to detail when they shop.
All the ARMs in this second group have 30-year terms, and do not permit negative amortization. They have initial rates that hold for 1, 3, 5, 7 or 10 years. In general, the longer the initial rate period, the higher the rate. This allows consumers to match their selection to their expectations about how long they will be in their house. If you know you will be out of the house within 5 years, for example, there is no point in taking a 7 or 10-year ARM, which will carry a higher rate than a 5-year ARM.
After the initial rate period ends, the rate is adjusted annually in every case. (After 7 years, for example, a 7-year ARM becomes a 1-year ARM). The new rate equals the current value of an interest rate index plus a margin of 2.75%, subject to a maximum rate over the life of the contract and to a maximum rate change on a rate adjustment date, termed the "rate adjustment cap".
All the ARMs in this group that I looked at used the Treasury one-year rate index. But there are other indexes that are as good or better, including: COFI, 12MTA, US Treasury Bills (12 months and shorter), 6-month CDs, 1-month Libor and 6-month Libor.
The maximum rate among this group of ARMs is 6% above the initial rate, although I found a few cases where it is 5%.
On all 1-year and 3-year ARMs, the rate adjustment cap is 2%.
All the 7-year and 10-year ARMs have 2 rate adjustment caps. The cap is 5% on the first adjustment and 2% on subsequent adjustments.
The major departure from standardization is in the first rate adjustment cap on 5-year ARMs. Of 15 5-year ARMs that I looked at, six have an initial adjustment cap of 2%, 4 have a cap of 3%, and 5 have a 5% cap. The second adjustment caps are all 2%.
The difference in rate adjustment caps will matter if interest rates increase sharply over the next 5 years. Consider two 5-years ARMs that are identical except that one has a 2% cap on the first rate adjustment while the other has a 5% cap. If the index after 5 years is 9%, the rate on the ARM with the 2% adjustment cap can only rise to 8% while the rate on the ARM with the 5% cap can rise to 11%. The borrower with the 5% cap would pay a high price in 5 years for not paying attention now.
The lenders offering 5% caps are providing nothing of value in return. They seem to be relying simply on the borrower's inattention to anything that does not affect them in the here and now.
"After reading a column of yours about all the things a borrower needs to know about adjustable rate mortgages (ARMs), I'm wondering how I juggle all these things when I shop for an ARM? Is there any standardization of features in this market that would allow me to focus my shopping on, say, just the rate and points, as I would if I were shopping for a fixed-rate mortgage (FRM)?"
To answer this question, I recently examined the ARMs offered by 16 major lenders. I found that most of the ARMs fell into two groups, one of which has tremendous diversity while the other has become fairly well (although not completely) standardized.
The first group of ARMs is designed mainly for borrowers who have difficulty in qualifying without a low initial interest rate. These ARMs adjust the rate frequently -- every month, every 3 months or every 6 months -- and many allow negative amortization and rising payments in the future.
You can read about one popular ARM of this type in Is a 3.95% ARM a Good Deal?
The focus of this column is the second group of ARMs, which is much easier to shop because of extensive, although not complete, standardization.
The major departure from standardization within this group applies to 5-year ARMs, which are now second only to one-year ARMs in popularity. Many borrowers taking 5-year ARMs are needlessly exposing themselves to a risk that can be avoided by more careful attention to detail when they shop.
All the ARMs in this second group have 30-year terms, and do not permit negative amortization. They have initial rates that hold for 1, 3, 5, 7 or 10 years. In general, the longer the initial rate period, the higher the rate. This allows consumers to match their selection to their expectations about how long they will be in their house. If you know you will be out of the house within 5 years, for example, there is no point in taking a 7 or 10-year ARM, which will carry a higher rate than a 5-year ARM.
After the initial rate period ends, the rate is adjusted annually in every case. (After 7 years, for example, a 7-year ARM becomes a 1-year ARM). The new rate equals the current value of an interest rate index plus a margin of 2.75%, subject to a maximum rate over the life of the contract and to a maximum rate change on a rate adjustment date, termed the "rate adjustment cap".
All the ARMs in this group that I looked at used the Treasury one-year rate index. But there are other indexes that are as good or better, including: COFI, 12MTA, US Treasury Bills (12 months and shorter), 6-month CDs, 1-month Libor and 6-month Libor.
The maximum rate among this group of ARMs is 6% above the initial rate, although I found a few cases where it is 5%.
On all 1-year and 3-year ARMs, the rate adjustment cap is 2%.
All the 7-year and 10-year ARMs have 2 rate adjustment caps. The cap is 5% on the first adjustment and 2% on subsequent adjustments.
The major departure from standardization is in the first rate adjustment cap on 5-year ARMs. Of 15 5-year ARMs that I looked at, six have an initial adjustment cap of 2%, 4 have a cap of 3%, and 5 have a 5% cap. The second adjustment caps are all 2%.
The difference in rate adjustment caps will matter if interest rates increase sharply over the next 5 years. Consider two 5-years ARMs that are identical except that one has a 2% cap on the first rate adjustment while the other has a 5% cap. If the index after 5 years is 9%, the rate on the ARM with the 2% adjustment cap can only rise to 8% while the rate on the ARM with the 5% cap can rise to 11%. The borrower with the 5% cap would pay a high price in 5 years for not paying attention now.
The lenders offering 5% caps are providing nothing of value in return. They seem to be relying simply on the borrower's inattention to anything that does not affect them in the here and now.